The speakers and panelists at this forum have spent the
day talking about what has happened in the five years since the
passage of FDICIA and what may lie ahead. I am here to add
another perspective: like the Ghost of Christmas Past, I will
take us back to the way things were -- in this case, to the way
things were in the banking crisis of the 1980s and early 1990s,
the crisis that led to the passage of the law.

It has been said that experience is a tough teacher --
first you get the test, then you learn the lesson. Bank
regulators were tested by the crisis, and learned lessons. Did
we learn the correct lessons?

When I became FDIC Chairman, I initiated a project to
find the answer to that question, an answer based on objective
analysis. The result is a series of 14 papers that the FDIC will
publish over the coming year. Next month, drafts of three
papers -- an overview, as well as an analysis of bank
examination and enforcement from 1980 through 1994 and an
analysis of off-site surveillance systems during the same period
-- will be presented at a symposium we are hosting. Although
our studies cover many other issues, I will focus today on our
findings relating to examination and supervision.

Effective bank supervision is critical to sound deposit
insurance. Without it, the insurer is potentially faced with
writing a blank check. It is also one of the important tools we
have for containing the problem of moral hazard that arises
from any form of insurance -- whether public or private. The
failure of the federal savings and loan insurance fund was a
direct result of the failure of supervision. It resulted in the
taxpayer writing a blank check. Without strong supervision,
deposit insurance simply becomes a public resource that risk
takers exploit.

While economic, legislative and regulatory forces all
contributed to a demanding environment for banking, the
more immediate cause of bank failures in the 1980s and early
1990s was a series of severe sectoral and regional recessions. In
agriculture, energy and commercial real estate -- and in the
Southwest, the Northeast and California -- the recession
followed periods of exuberant expansion often characterized by
speculative activity. In all these cases, the conventional
wisdom was that the boom would not end. Regulators, too,
overreacted to the good times by becoming complacent.

Moreover, two decisions that were embraced by the
Office of the Comptroller of the Currency and the Federal
Deposit Insurance Corporation -- and to some extent by the
Federal Reserve System -- to change examination policies
during the late 1970s and early 1980s had an important
negative impact on the outcome and severity of the crisis that
was to follow. Those two decisions were (1) to place relatively
more weight on off-site supervision and relatively less upon
on-site examinations and (2) to concentrate examination resources
on those institutions that posed the greatest risk to the
insurance fund and the stability of the financial system. Both
decisions ultimately resulted in fewer field examiners and
reduced numbers of examinations for most of the 1980s,
weakening the ability of bank supervisors to detect -- and
respond to -- problems.

The total number of state and federal examiners
declined by 13 percent from 1980 to 1984. The OCC and the
FDIC experienced a greater decline of 17 percent. Even after
hiring resumed, it was not until 1987 that the examiner force --
federal and state -- was restored to 1980 levels. In the
meantime, the number of annual bank failures increased from
10 to 184 between 1980 and 1987, while the number of troubled
banks increased from 217 to 1,575 over the same period.

The decline in the number of examiners led to marked
changes in the frequency of examinations. In 1980, the average
length of time between examinations was 15 months. By 1986,
the average interval had increased to 20 months -- and in the
most extreme cases, had increased to seven years. The greatest
change was for CAMEL 1-rated banks, whose average interval
increased from 15 to 28 months between 1980 and 1986.

With that background, today I will highlight six of the
findings of our historical study -- findings based on evidence
that, indeed, we regulators learned -- and are applying -- the
correct lessons from our experience.

Lesson #1 -- There is no substitute for regular, on-site
examinations of depository institutions for addressing specific
problems at individual institutions. On-site examinations
generate information on the condition of banks that is not
available from any other source.

During the 1980s, examination ratings that were up-to-date
generally identified most of the banks that required
increased supervisory attention well before the bank actually
failed. Examinations were generally effective in identifying
problem banks in a two-to-three year window prior to failure.
As we have seen, however, the problem was that far too many
examinations were out-of-date, and could not, therefore, serve
the function of identifying current difficulties in the industry.
Of the 1,617 banks that failed in 1980 through 1994, 36 percent
had CAMEL ratings of "1" or "2" two years prior to failure.

FDICIA, of course, requires annual full-scope
examinations for all banks, except that an 18-month interval
can be substituted for small banks with satisfactory ratings.

Lesson #2 -- Even though up-to-date CAMEL ratings
were generally successful in identifying banks that required
greater supervisory attention, they had limitations. Because
CAMEL ratings are based on the internal operations of the
bank, they do not take into account economic developments
that may pose future problems. This partly explains why 1- or
2-rated institutions could fail only two years later.

We at the FDIC have created a Division of Insurance to
monitor economic developments; to provide data to our
supervisory staff, as well as to the staffs of the other regulatory
agencies; and to make economic risk assessments available to
the industry in order to bridge the gap between the individual
institution and the economic environment in which it operates.
We are also developing a model for projecting bank failures
that will incorporate regional and macroeconomic information
in the forecast, which up to now has been based solely on
supervisory and historical information.

Lesson #3 -- Because CAMEL ratings are generally a
measure of the current condition of the bank at the time it is
examined, they do not systematically track risk factors that
may produce future losses. In response to this lesson, all of the
regulatory agencies today have programs aimed at tracking
risk. At the FDIC, for example, we have developed a flow
chart for our examiners to use in tracking interest rate risk. It
reflects a graduated approach to determining the risk exposure
of an institution -- the more risk the examiner finds, the more
steps he or she must take.

We are now field testing 10 more flow charts that cover
areas ranging from underwriting and credit administrative
practices to loan review systems to insider transactions. The
purpose of this structured risk-assessment approach is to look
beyond the examination date to how a bank can respond to
changing market conditions in the context of its individual risk
profile.

Most recently, the CAMEL rating system has been
updated to become CAMELS to emphasize risk assessment
and the risk profile of the institution.

Lesson #4 -- Once troubled institutions were identified
during the 1980-94 period, they were subjected to supervisory
and enforcement actions that were by and large effective in
reducing failures and losses to the insurance fund. About one-half
of all banks rated "4" or "5 by the FDIC from 1980
through 1994 were the subject of formal enforcement actions;
many of the remaining banks received informal enforcement
actions.

About 75 percent of all problem banks recovered, while 25
percent failed.

As opposed to the thrift experience, bank supervisory
actions led to lower asset growth, reduced dividend payments,
and increased capital injections at troubled banks.
This had the effect of limiting risk-taking by problem banks
and limiting losses to the insurance fund when the banks failed.

Lesson #5 -- While capital is important as a cushion to
protect banks from failure and the insurance funds from loss,
even sizable capital will not save an institution with significant
problem assets and a high risk profile. We looked at banks in
1982 and separated them into two groups. The first group
survived the next five years. The second were the banks that
failed in 1986 and 1987.

In 1982, the banks that did not fail had an average
equity ratio of 8.84 percent, while failed banks had a ratio of
8.29 percent, only 55 basis points lower. Moreover, 8.29
percent -- the lower number -- is above the level needed to be
considered well-capitalized under the risk-based system now in
effect.

Capital is a lagging indicator of the health of an
institution -- an important point in weighing the significance of
the prompt corrective action requirements of FDICIA.
Examiners analyze considerably more information than capital
ratios to determine a bank's likelihood of failure.

The real value of prompt corrective action, therefore,
may be that the regulators must maintain a staff of examiners
sufficient to meet its demands and the demands of mandated
regular examinations. In light of the experience in the early
1980s, that is valuable.

Lesson #6 -- Based on the experience of the 1980s, risk
factors can be used to identify groups of banks that have a
higher risk of failure.

For example, the banks that failed in the years 1982
through 1987 had distinctly higher risk profiles in 1982 than
banks that did not fail. They had higher loan-to-asset ratios
than survivors. They had substantially higher ratios of interest
and fee income on their loan and lease portfolios, which
suggests that their loans were riskier. They also had higher
growth rates than the banks that did not fail, but these growth
rates were sharply cut back as the banks approached failure, as
FDIC enforcement actions took effect.
This finding suggests that the focus on risk assessment in
current supervisory thinking is on target.

Beyond these and other specific lessons that our studies
confirm, the FDIC's history of the eighties and early nineties
project reinforces the general lesson from that time: that
balance is the key to success in both regulating banks and
managing deposit insurance.

In banking regulation, balance means that we recognize
that when things are going badly, the pendulum has a way of
swinging back -- and when things are going well, the pendulum
will someday swing the other way, too. We regulators can
maintain this balance only if we follow the basic principles of
bank supervision both in good times and in bad.

During good times, we must be alert to problems and
do something about them before they result in severe problems
for the banking system. We must be just as realistic when the
cycle turns down as we are when the cycle is on the upswing.
Banks are in the business of accepting risk as financial
intermediaries and of making a profit. We should not fall into
the mindset that problems lurk under every rock and in every
loan file. We should justify the balance we maintain as
regulators on the basis of fact and critical analysis.

Balance in managing deposit insurance means assuring
stability in the financial system while addressing the problem
of moral hazard that arises from public, or private, deposit
insurance. By protecting depositors against loss, deposit
insurance virtually eliminates the risk of bank runs and
disruptive breakdowns in bank lending that damage the
economy.

On the other hand, by assuming the risk of losses that
would otherwise be borne by depositors, deposit insurance
provides incentives for increased risk-taking by bank
management, thereby exposing the insurance fund to greater
losses. Moral hazard is a particularly serious concern if the
institution is nearing insolvency. Then, the owners have strong
incentives to make risky investments because profits accrue to
the owners, while losses fall on the deposit insurance fund.

In the 1980s, the balance tipped in favor of stability. In
assuring stability, the FDIC was eminently successful. Stability
was achieved, however, at great cost -- and with respect to
savings and loan failures, at great cost to the taxpayers.
FDICIA was the Congress' call to us to restore the balance by
giving more attention to the problem of moral hazard.

In carrying out the requirements of FDICIA -- and
pursuing other initiatives -- we are doing so through risk-based
and higher minimum capital standards, risk-related deposit
insurance premiums, the least-cost test for resolving bank
failures, and national depositor preference.

First, the development of internationally-accepted risk-based
capital standards is one of the most significant innovations in
the history of banking regulation. The Basle Committee on Banking
Supervision has laid out a framework for assessing an institution's
capital adequacy by weighing its assets and off-balance sheet
exposures on the basis of counterparty risk. Moreover, recognizing
that international banks have been actively involved in trading
securities and derivative products, the Committee has developed
progressive standards through the use of standardized and internal
models to measure the unique market risks of specific portfolios.

Second, higher minimum capital standards are enforced
through prompt corrective action. The principle embedded in
prompt corrective action is gradation of risk and of
appropriate regulatory response: The less capital a bank has,
the smaller the cushion it has to absorb losses, and the greater
the risk it poses to the insurance fund. The greater the risk,
the more attention it should receive from regulators, but strong
capital, as we have seen, is a necessary but not sufficient
condition for safe and sound banking.

Third, the principle of gradation of risk and response is
also reflected in our system of risk-related FDIC insurance
premiums. The greater the risk, the higher the premiums the
institutions pay. Risk-related premiums promote safety and
soundness -- and help to address the issue of moral hazard --
by giving institutions an economic incentive -- through lower
deposit insurance premiums -- to improve their conditions and
maintain lower risk profiles.

The deposit insurance premium for an individual
institution is now established on the basis of its capital and
supervisory ratings -- with three categories of each and a nine-block
grid. Currently, 94 percent of institutions insured by
the Bank Insurance Fund and 89 percent of the institutions
insured by the Savings Association Insurance Fund are in the
FDIC's best category for deposit insurance premiums, which
means these institutions are both well-capitalized and either 1-
or 2-rated.

We are analyzing whether other factors are relevant to
risk to the insurance funds -- and whether the nine-block grid
for setting deposit insurance premiums should be expanded.
We are also examining whether our current 27-basis point
spread is sufficient to price the risks to the insurance funds
posed by individual institutions. Those are questions that we
will give a lot of attention to during the next year.

Fourth, in resolving bank failures, the FDIC is required
by FDICIA to accept the proposal from a potential purchaser
that is the least costly to the deposit insurance fund of all the
proposals we receive. After the law took effect, in more than
half of the failures in 1992 -- 66 out of 120 -- uninsured
depositors received less than 100 cents on each dollar above
$100,000. That was a significant increase in uninsured
depositors experiencing losses from 1991, when fewer than 20
percent of the failures involved a loss for uninsured depositors.
While the number of bank failures in 1992 was lower than in
previous years, the number of uninsured depositors
experiencing a loss was significantly greater.

Finally, the passage of a national depositor preference
law in 1993 gave creditors of banks other than depositors an
extra incentive to be concerned about the condition of their
institutions. If a bank fails, anyone with a non-deposit claim
gets nothing until all depositors, including the FDIC as insurer,
have been made whole. It is still too early to assess the impact
of this statutory change.

Conceptually, higher risk-based and minimum capital
standards, risk-related deposit insurance premiums, and the
least-cost test for resolving bank failures are direct and indirect
surrogates for the discipline that depositors would logically
impose if they had access to the economist's dream: perfect
information in a purely competitive market.

In conclusion, we have been working to improve our
system of banking regulation and supervision -- including the
safety net -- for more than a decade. The banking crisis of the
1980s and early 1990s exposed weaknesses in the banking
system -- and in the system of bank regulation. FDICIA was a
reaction, but not the only one. Fortunately, regulators have
continued to work beyond FDICIA's bounds to find better
ways of responding to supervisory issues.

The Ghost of Christmas Past came with the message
that the past was prelude to the future. In the euphoria of a
year when the commercial banking industry is likely to make
$50 billion in profits for the first time, perhaps we, too, can
benefit from reflecting on that message. We have seen in our
history of the 1980s and early 1990s project, it took years for
problems at banks to surface.

In the end, the chief lesson of the 1980s is a clear one:
there is a continuing, strong need for effective and balanced
supervision.